The recent decision made by Judge Victor Marrero of the Southern District of New York is of critical importance to the NFT industry. For the first time, a court ruled that the issuer of an NFT offered an “investment contract” and therefore could potentially be held liable for the sale of unregistered securities. The decision was made in the context of denying Dapper Lab’s motion to dismiss Friel vs. Dapper Labs – meaning that the plaintiffs, at the pleading stage, accepting the allegations of the amended complaint as true, state a valid cause of action as a matter of law.
An NFT (non-fungible token) can be thought of as a unique cryptographic key contained in a digital token on the blockchain that verifies that the corresponding content file is genuine. It is most often used with music or art.
Defendant Dapper Labs is the company originally known for CryproKitties. It ran on the Ethereum blockchain. But Dapper Labs then developed its own blockchain, called Flow, to house NBA Top Shot, their collaboration with the NBA. Top Shot is best known for selling “Moments”, which are often compared to sports cards. Dapper Labs clips NBA highlights and turns them into NFTs, which can be bought and sold.
The lawsuit alleged that the NFTs sold by Dapper Labs on its platform constituted unregistered securities that were sold in violation of federal securities laws. According to the complaint, Moments are “securities” because, among other things, they “constitute an investment of money in a joint venture with a reasonable expectation of profit from the efforts of others.” That language, of course, comes from the well-known Howey test that has been used by the SEC for decades to determine whether something is a security – including with respect to ICOs. Not surprising, Howey was at the heart of the court’s decision, and the court held that the allegations of the amended complaint “provided each consideration under Howey facially plausible.”
The first Howey factor – an investment of money – was easy for the court because it was not disputed. The second factor – whether it is a “joint enterprise” – was not as straightforward. The court applied both the horizontal community test and the vertical community test.
As the Court explained, horizontal community exists when two considerations are established: (1) a sharing or pooling of investors’ funds and (2) that “the assets of each investor in a pool of investors” are related to each other and to “the success of the overall investment.” Dapper Labs’ sale of packets of Moments and the transaction fees on the Marketplace (which the court defined as the secondary marketplace, hosted on the NBA Top Shot application and created and controlled by Dapper Labs) generate revenue used to support and expand the blockchain, which was sufficient to support a reasonable finding of merger. This conclusion was further supported by the claim that buyers’ capital was then held by Dapper Labs in Dapper-controlled wallets. And the court held that the plaintiffs sufficiently alleged that the buyers’ assets were tied to the overall success of Dapper Labs because they alleged that Dapper Labs controlled the enterprise, including the “Flow Blockchain” that Moments sits on top of, and that Moments, once purchased in packages, can only sold on Marketplace, which in turn is controlled by Dapper Labs.
With respect to vertical community, the Second Circuit recognizes only so-called “strict vertical community, where a plaintiff must establish that the fortunes of the plaintiff and defendant are linked so that they rise and fall together.” The court was not persuaded by the plaintiffs’ argument that Dapper Labs’ charging of a 5% fee on each transaction in the marketplace was sufficient to establish strict vertical equality.
During the final Howey factor, the plaintiffs had to show that Dapper Lab’s offer of Moments on NBA Top Shot came with “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” In the Second Circuit, it means “whether, in all circumstances, the scheme was primarily promoted as an investment.” This expectation of the merit test is objective.
The court found that the defendant’s public statements and marketing materials objectively led buyers to expect profits. Dapper Labs’ tweets recently promoted sales. Although the word “profit” was not used there, the court held that stock charts and rocket ship emojis sent a similar message. The court also mentioned that Dapper Labs markets Moments based on scarcity by offering so-called common, rare, legendary and other premium packages. And the court said that conclusion was supported by the subjective observations of buyers and those reporting on the NBA Top Shot offers.
The court then addressed the requirement that the promise of profit must be “derived from the entrepreneurial or managerial efforts of others.” It said:
It is likely that Moments’ value is derived almost entirely from Dapper Labs’ continued operation of the Flow Blockchain, which enables price transparency (thus affecting its value) but, perhaps more critically, appears to give buyers the ability to trade in it at all . Defendants’ failure to acknowledge the blockchain technology underlying Moments is fatal to their motion in this regard. Without Dapper Labs’ continued maintenance of the Flow Blockchain and the plaintiffs’ “token that powers it all,” FLOW [amended complaint] plausibly claims that Moments would have no value. …
And because Moments can only be purchased from NBA Top Shot in packs, or traded on the marketplace that Dapper Labs controls, Dapper Labs’ continued leadership and efforts to develop the ecosystem, both technologically and as a matter of marketing, are critical to Moments retaining and increases in value.
Finding that the allegations in the amended complaint satisfied Howey factors, the court denied the defendant’s motion to dismiss.
The decision is clearly not a position that all NFTs are securities. Noting specifically that the decision was “narrow,” the court also said, “Not all NFTs offered or sold by any company will constitute a security, and each arrangement must be considered on a case-by-case basis.” The critical factor here was the “specific arrangement” with which Dapper Labs offered Moments. Of particular importance to the court was that Dapper Labs maintained private control over the Flow Blockchain, which significantly, if not entirely, dictated Moment’s use and value. And, “without Dapper Lab’s essential efforts to sustain the Flow Blockchain and Marketplace, Moments would be worthless.”
Thus, NFT creators will be in a better position to avoid the same fate as Moments if they use a public blockchain and do not create a specialized token. Or, if they want to use a private blockchain, the Dapper Labs decision offers a good roadmap of steps to take to try to avoid meeting Howey test.
